On economic integration with India

A few weeks ago, when its stocks went public, I quipped in facebook that the company’s valuation was about the same size as Bangladesh’s economy.* A friend commented something to the effect that Bangladeshi economy would be much larger if only it was integrated with India. Now, this friend of mine is a PhD student in a major western university, and has worked in positions that can affect policy and politics in Bangladesh. When people like him believe Bangladesh is missing out on some magic GDP by not being sufficiently integrated with India, one has to think seriously.

One doesn’t have to look very hard for the source of this belief. People like Farooq Sobhan of BEI or Mustafizur Rahman of CPD have claimed publicly in the past that economic integration with India would raise growth rate to 8% or more. Sobhan was actually quoted in the Economist thus. The thing is, I’ve never seen any economic modelling that shows exactly how growth rate would jump by ‘full economic integration’ with India.

In fact, I’ve never seen any proper, academic work that explains what the full economic integration actually means when it comes to India and Bangladesh. Of course, I don’t presume to know everything that has been written about the subject. I shall be much obliged if someone can point me to some literature on this. And as a card carrying (neo)liberal economist, I am fully signed up to the idea of free trade and factor mobility — so if economic integration means open borders, then I am all for it even if growth remains at 6-7% rather than 8%.

But I am quite sceptic about economic integration with India raising the growth rate.

Let’s go with the maximum definition of economic integration with India. Let’s assume that Bangladesh is an Indian state as far as the economy goes. That is, let’s keep keep Amar Shonar Bangla, and the cricket team, and the flag, and the shapla, and Islam-as-the-state-religion. But instead of taka, let’s have the Indian rupee, and let’s allow Indians to come and work in Bangladesh and Bangladeshis to work in India — that is, no border killing, and let’s have no customs at the borders. Bangladesh government can have some taxes, and can be in charge of development expenditures and service deliveries (that is, health, education, law and order), but most of the taxes and all of defence and foreign affair will be decided in New Delhi. Hasina Wajed or Khaleda Zia can have the title of Prime Minister, but at least as far as economic matters are concerned, let’s give them exactly the same set of powers that Mamata Banerjee has.

In this world, economic theory would suggest that all else equal, Bangladesh should grow faster than its recent pace of 6-7%. This is because Bangladesh being much poorer than the Indian average will catch up when fully integrated.

The snag is, convergence doesn’t actually seem to be holding among Indian states.

This is shown in the chart. In this chart, each dot represents an Indian state. The horizontal axis shows the per capita income in 2000, while the vertical axis shows growth rate per year in the period 2000-08 — the period of shining, rising India. If the convergence theory held during those boom years, we would expect to see a negative correlation in this chart — poorer states in 2000 would be expected to have a faster growth rate.

In fact, we see nothing of that kind. Instead, what we see is that during the 2000-08 period, Indian states diverged! That is, richer Indian states grew faster. States like Gujerat or Haryana were about twice as rich as states like Jharkhand or Uttar Pradesh in 2000. Over the next eight years, the former ones grew by 8-9% a year, the latter by around 5% or so.

Around 2000, Bangladesh’s per capita income was around 20,000 Indian rupee. Plug that into the scatter plot and we get growth of around 6-6.5% over the next eight years — about what happened in reality.

Okay, these numbers should be taken with caution. Indian state data is not of particularly good quality. But anyone familiar with the Indian economic story would know that the economic boom in India hasn’t been widely shared, that some parts of India have grown much faster than others, and the relatively poorer parts have fallen even further behind. Why this is so and what it means for policy is an area of lively debate among academics, activists, and policymakers — and is not relevant for the post.

Also, one could argue that the scatter plot should be augmented by factors such as resource endowment, human capital, governance and other factors. And I suspect once those measures are taken into account, Indian states will probably show ‘conditional convergence’.

The relevant point here, however, is that one needs to take into account these intra-state differences to get convergence within India. Just being a part of India didn’t mean a given Indian state benefitted as much from the boom of 2000-08 as other states did.

Why then would economic integration with India raise Bangladesh’s growth rate if, for example, we failed to get financing for bridges because of corruption?

By embellishing the benefits of economic integration with India, people like Faruq Sobhan actually do a great disservice. Not only do they harm the prospect of a friendly relationship with the neighbour, they detract from focussing on what really matters for growth.

*As DS pointed out there, my quip was conflating stocks and flows — but this isn’t relevant for the post.

**Data source: Groningen Growth and Development Centre for the per capita income in PPP US$; CEIC Asia for the convergence chart.

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We can actually use the literature to approximate how much Bangladesh should grow by if convergence holds. The literature suggests that for every log point difference between two countries’ initial level of per capita GDP, per capita GDP in the poorer country should be greater than that of the richer country by the convergence coefficient, which is typically estimated to be about 2%. In 2010, India’s per capita GDP in PPP dollar was about 3,600, while Bangladesh’s was about 1,800. The log point difference between the two countries’ 2000 per capita GDP is thus about 2/3. Multiply that by the convergence factor of 2, and we get 1.5. That is, Bangladeshi per capita GDP should grow 1.5 percentage point faster than India, on average. If India’s per capita GDP grows by, say, 5% in the medium term, the Bangladesh’s should grow by 6.5%. Add 1% population growth, and the economy should grow by 7.5% a year.

Full economic integration with India could raise Bangladesh’s average rate of economic growth from 6% to 8%, estimates Farooq Sobhan, the president of the Bangladesh Enterprise Institute, a Dhaka think-tank. Now, says Mr Sobhan, for the first time, there is agreement that “unresolved problems should not stand in the way of things that can be done.”

8 Responses

An excellent, excellent question, and an excellent excellent post! Thank you. A larger article on this by you would be a very useful contribution to a debate that is generally carried out in rather vapid terms. Some rapid-fire, disorganized, thoughts: A related approach to the question might break things down by sector and ask where the growth is to come from – surely there are complementarities, and not. You also ask if greater integration will suddenly improve the governance issues that surely cut into growth. Applying the Johnson-Acemoglu institutions framework here might be useful too: what impact would integration have on existing institutional arrangements? The monetary union issues too are fascinating. There’s a number of prominent folks in the last few years who spoken up on the need/desire for a monetary union in South Asia a la Europe. I wonder if they are so sanguine about such proposals today in 2012.

I think you missed out on some aspects of the analysis. The statewise per-capita income for a country can never show the true picture of the people belonging to that state, because of free migration available – something that’s not true for a different country. You can think of Biharis who are migrating to Gujarat for working in a factory. The per-capita income of Gujarat gets increased by that, not the same of Bihar. And there’s no remittance-effect here since the whole family moves to Gujarat and become a voter overnight. So, for a country where migration is free – development reaches everywhere through migration. It would have been interesting if we could have developed similar statistics for state-per-capita-GDP considering all people born in that state. West Bengal has largely missed out on the IT boom India had, but did that reduce average income of Bengalis? Probably yes, but not to the extent you think it should.

The other part are the social indicators. Even though Bangladesh does at per with poorer Indian states in economics, it does far better than them in all social indicators. So, Bangladesh invested on these instead of economics, there’s no reason to think Bangladesh would play a “catch-up”, rather poorer Indian states might play a catch-up to social side.

The only “feasible” financial union India and Bangladesh can have right now is in form of a FTA, which would be more beneficial to India than to Bangladesh (as suggested by World Bank study). Due to political considerations, I doubt there would be any possibility of free labor migration anytime soon. After all, countries partitioned voluntarily few decades back will have to see real incentives in order to form any sort of unions.

Diganta, I am sure I missed a lot, but I am not sure this is necessarily correct: “for a country where migration is free – development reaches everywhere through migration”. Typically, capital is far more mobile than labour. In developed economies, lagging regions catch up in per capita income because both people move from poor parts to richer ones but also because capital flows into the poorer parts. What happens then is that some parts (New York city, Silicon Valley, London etc) have proportionately higher income level than rest of the country, which is explained by their special characteristics. That is, there is conditional convergence.

Perhaps there has been conditional convergence in India. If you regress the growth rate on not just initial income, but also throw in other factors, perhaps there is convergence. But as I said, that’s not relevant for refuting Farooq Sobhan’s claim. He claims that ‘full integration’ means faster growth. Most straightforward way of getting that is absolute, not conditional, convergence. India hasn’t had absolute convergence. If Bangladesh was an Indian state (for economic purposes), then why would we expect faster growth?

As it happens, you can estimate per capita income for people born in a state. You can get birth and death rates of, say, West Bengal over the past century. Then you can work out what the state’s population should have been if there was no migration (in or out). The difference between that hypothetical series and the actually reported population is a good proxy for net migration.

Bangladesh having relatively good social indicators is beside the point. Sobhan et al’s claim is about growth rate, nor social indicators. They are not saying economic integration will mean more people will be educated or people will live longer. They are saying it will raise growth rate (which, all else equal, should mean even better social indicator).

Pegging against the rupee is a non-starter. In Bangladesh, some people fear “becoming like Nepal or Bhutan” every time a dog barks. Well, pegging the taka against rupee would make Bangladesh like Nepal or Bhutan, who peg their currencies against the rupee.

And there are sound macro-economic reasons why we should not become like Nepal or Bhutan in this regard. Since the 1960s, macroeconomists have been aware of the impossible trinity which holds that a country can, at once, achieve only two and never three of the following: fixed exchange rate, capital mobility, and monetary policy independence.

If the taka is fixed against the rupee, this would mean our authorities would have to choose either capital mobility between the two countries, or monetary policy independence. Given weak institutions, it would be practically impossible to restrict capital mobility across our porous border. This means a peg against the rupee will result in effectively ceding monetary policy to the Reserve Bank of India.

This won’t involve any elaborate state protocol. Most paranoid Indophobes in Dhaka wouldn’t probably even notice it. But it would mean every time the RBI changes monetary policy, we would have to match it, regardless of our domestic conditions. If the RBI tightens monetary policy, and we didn’t want to because of weak domestic conditions, there would be capital flight and we could be threatened with a currency crisis. Alternatively, if the RBI loosened monetary policy, but we had inflation worries, there would be hot money flowing in, and the inflation problem would worsen.

And finally, what impact would integration have on institutions? Well, right now political disfunction means military coup. If we were an Indian state, that wouldn’t happen. So perhaps institutions would have been better. On the other hand, for most people in Bangladesh, identity politics isn’t an issue. That wasn’t the case when we were part of India (or Pakistan). And identity politics isn’t conducive to institution-building. Which of these factors would dominate? That’s a very interesting question.

I don’t know how pegging Taka with Rupee makes sense … monetary union would make Bangladesh fully dependent on Indian economy.

I agree that India didn’t converge at all. India wants to be (at least as per constitution) union of states – so, states might run in opposite directions and not converge at all.

Whether economic growth wold translate into better social indicators – is a different debate. I strongly believe Bangladesh wont be able to keep low Gini Coeff once it enters with closer ties with India.

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